ps13Q&A - ECONOMICS 205 PRINICIPLES OF MACROECONOMICS...

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ECONOMICS 205: PRINICIPLES OF MACROECONOMICS MARK MOORE PROBLEM SET 13 1. What is the nominal exchange rate? What is the real exchange rate? The nominal exchange rate (E) is the relative price of home and foreign currencies. The real exchange rate is the relative price of home and foreign goods. Suppose we compare the United States and Europe. Define the U.S. exchange rate in units of €/$, so that an increase in E (more euros per dollars) implies an appreciation of the dollar. The U.S. real exchange rate (with respect to Europe) is defined as EP/P*, where E is defined as above, P is the price of U.S. goods, and P* is the price of European goods. Essentially, the real exchange rate has units of European goods/U.S. goods. An increase in the real exchange rate (more European goods per U.S. goods) implies a real appreciation. 2. How does a nominal depreciation of the home currency affect the trade balance in the short run? Using the definition of the real exchange rate, a depreciation of the home currency (decrease in E) implies a real depreciation, given price levels. In fact, prices change relatively slowly, so that in the short run the real and nominal exchange rates tend to move together (except for high inflation economies). A real depreciation means home goods become cheaper relative to foreign goods, which tends to improve the trade balance (more exports, less imports). So, a nominal depreciation usually implies a real depreciation, which tends to improve the trade balance. 3. Baumol and Blinder, Ch. 18, (p. 364 in 2007 Update), Discussion Question 3. Purchasing power parity (PPP) predicts that the dollar should depreciate at a rate equal to the difference between U.S. and German inflation. So, the dollar should have depreciated against the mark. This, in fact, did not occur. Instead, the dollar appreciated. PPP theory has little validity over short time periods, and is not always a good guide to exchange rate. It is helpful over longer time periods, to help predict the effects of ongoing inflation on the exchange rate. Many other things were happening in the early 1980s. For example, U.S. interest rates were very high, a factor that would tend to make the dollar appreciate. 4. Suppose a new study estimates the dollar is likely to depreciate by 75% over the next decade to help alleviate the U.S. trade deficit.
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